The first article below, from The Economist, examines likely macroeconomic policy under Donald Trump. He has stated that he plans to cut taxes, including reducing the top rates of income tax and reducing taxes on corporate income and capital gains. At the same time he has pledged to increase infrastructure spending.

This expansionary fiscal policy is unlikely to be accompanied by accommodating monetary policy. Interest rates would therefore rise to tackle the inflationary pressures from the fiscal policy. One effect of this would be to drive up the dollar and therein lies significant risks.

The first is that the value of dollar-denominated debt would rise in foreign currency terms, thereby making it difficult for countries with high levels of dollar debt to service those debts, possibly leading to default and resulting international instability. At the same time, a rising dollar may encourage capital flight from weaker countries to the US (see The Economist article, ‘Emerging markets: Reversal of fortune’).

The second risk is that a rising dollar would worsen the US balance of trade account as US exports became less competitive and imports became more so. This may encourage Donald Trump to impose tariffs on various imports – something alluded to in campaign speeches. But, as we saw in the blog, Trump and Trade, “With complex modern supply chains, many products use components and services, such as design and logistics, from many different countries. Imposing restrictions on imports may lead to damage to products which are seen as US products”.

The third risk is that the main beneficiaries of Trump’s likely fiscal measures will be the rich, who would end up paying significantly less tax. With all the concerns from poor Americans, including people who voted for Trump, about growing inequality, measures that increase this inequality are unlikely to prove popular.

Articles

Questions

What should the Fed’s response be to an expansionary fiscal policy?

Which is likely to have the larger multiplier effect: (a) tax revenue reductions from cuts in the top rates of income; (b) increased government spending on infrastructure projects? Explain your answer.

What is the relationship between the degree of inequality in a country and the rate of economic growth? The traditional answer is that there is a trade off between the two. Increasing the rewards to those who are more productive or who invest encourages a growth in productivity and capital investment, which, in turn, leads to faster economic growth. Redistribution from the rich to the poor, by contrast, is argued to reduce incentives by reducing the rewards from harder work, education, training and investment. Risk taking, it is claimed, is discouraged.

Recent evidence from the OECD and the IMF, however, suggests that when income inequality rises, economic growth falls. Inequality has grown massively in many countries, with average incomes at the top of the distribution seeing particular gains, while many at the bottom have experienced actual declines in real incomes or, at best, little or no growth. This growth in inequality can be seen in a rise in countries’ Gini coefficients. The OECD average Gini coefficient rose from 0.29 in the mid-1980s to 0.32 in 2011/12. This, claims the OECD, has led to a loss in economic growth of around 0.35 percentage points per year.

But why should a rise in inequality lead to lower economic growth? According to the OECD, the main reason is that inequality reduces the development of skills of the lower income groups and reduces social mobility.

The lower educational attainment applies both to the length and quality of education: people from poorer backgrounds on average leave school or college earlier and with lower qualifications.

But if greater inequality generally results in lower economic growth, will a redistribution from rich to poor necessarily result in faster economic growth? According to the OECD:

Anti-poverty programmes will not be enough. Not only cash transfers but also increasing access to public services, such as high-quality education, training and healthcare, constitute long-term social investment to create greater equality of opportunities in the long run.

Thus redistribution policies need to be well designed and implemented and focus on raising incomes of the poor through increased opportunities to increase their productivity. Simple transfers from rich to poor via the tax and benefits system may, in fact, undermine economic growth. According to the IMF:

That equality seems to drive higher and more sustainable growth does not in itself support efforts to redistribute. In particular, inequality may impede growth at least in part because it calls forth efforts to redistribute that themselves undercut growth. In such a situation, even if inequality is bad for growth, taxes and transfers may be precisely the wrong remedy.

Data

Questions

Explain what are meant by a Lorenz curve and a Gini coefficient? What is the relationship between the two?

The Gini coefficient is one way of measuring inequality. What other methods are there? How suitable are they?

Assume that the government raises taxes to finance higher benefits to the poor. Identify the income and substitution effects of the tax increases and whether the effects are to encourage or discourage work (or investment).

How will the balance of income and substitution effects vary in each of the following cases: (a) a cut in the tax-free allowance; (b) a rise in the basic rate of income tax; (c) a rise in the top rate of income tax? How does the relative size of the two effects depend, in each case, on a person’s current income?

Identify policy measures that would increase both equality and economic growth.

Would a shift from direct to indirect taxes tend to increase or decrease inequality? Explain.

By examining Tables 3, 26 and 27 in The Effects of Taxes and Benefits on Household Income, 2012/13, (a) explain the difference between original income, gross income, disposable income and post-tax income; (b) explain the differences between the Gini coefficients for each of these four categories of income in the UK.

The publication looks at the distribution of income both before and after taxes and benefits. It divides the population into five and ten equal-sized groups by household income (quintiles and deciles) and shows the distribution of income between these groups. It also looks at distribution within specific categories of the population, such as non-retired and retired households and different types of household composition.

The data show that the richest fifth of households had an average pre-tax-and-benefit income of £81,284 in 2012/13, 14.7 times greater than average of £5536 for the poorest fifth. The richest tenth had an average pre-tax-and-benefit income of £104,940, 27.1 times greater than the average of £3875 for the poorest tenth.

After the receipt of cash benefits, these gaps narrow to 6.6 and 11.0 times respectively. When the effect of direct taxes are included (giving ‘disposable income’), the gaps narrow further to 5.6 and 9.3 times respectively. However, when indirect taxes are also included, the gaps widen again to 6.9 and 13.6 times.

This shows that although direct taxes are progressive between bottom and top quintiles and deciles, indirect taxes are so regressive that the overall effect of taxes is regressive. In fact, the richest fifth paid 35.1% of their income in tax, whereas the poorest fifth paid 37.4%.

Taking the period from 1977 to 2012/13, inequality of disposable income (i.e. income after direct taxes and cash benefits) increased from 1977 to 1988, especially during the second two Thatcher governments (1983 to 1990) (see chart opposite). But then in the first part of the 1990s inequality fell, only to rise again in the late 1990s and early 2000s. However, with the Labour government giving greater cash benefits for the poor, inequality reduced once more, only to widen again in the boom running up to the banking crisis of 2007/8. But then, with recession taking hold, the incomes of many top earners fell and automatic stabilisers helped protect the incomes of the poor. Inequality consequently fell. But with the capping of benefit increases and a rise in incomes of many top earners as the economy recovers, so inequality is beginning to rise once more – in 2012/13, the Gini coefficient rose to 0.332 from 0.323 the previous year.

As far as income after cash benefits and both direct and indirect taxes is concerned, the average income of the richest quintile relative to that of the poorest quintile rose from 7.2 in 2002/3 to 7.6 in 2007/8 and then fell to 6.9 in 2012/13.

Since the start of the economic downturn in 2007/08, the average disposable income has decreased for the richest fifth of households but increased for the poorest fifth.

Cash benefits made up over half (56.4%) of the gross income of the poorest fifth of households, compared with 3.2% of the richest fifth, in 2012/13.

The average disposable income in 2012/13 was unchanged from 2011/12, but it remains lower than at the start of the economic downturn, with equivalised disposable income falling by £1200 since 2007/08 in real terms. The fall in income has been largest for the richest fifth of households (5.2%). In contrast, after accounting for inflation and household composition, the average income for the poorest fifth has grown over this period (3.5%).

This is clearly a mixed picture in terms of whether the UK is becoming more or less equal. Politicians will, no doubt, ‘cherry pick’ the data that suit their political position. In general, the government will present a good news story and the opposition a bad news one. As economists, it is hoped that you can take a dispassionate look at the data and attempt to relate the figures to policies and events.

Questions

How does the receipt of benefits in kind vary across the quintile groups? Explain.

What are meant by the Lorenz curve and the Gini coefficient and how is the Gini coefficient measured? Is it a good way of measuring inequality?

Paint a picture of how income distribution has changed over the past 35 years.

Can changes in tax be a means of helping the poorest in society?

What types of income tax cuts are progressive and what are regressive?

Why are taxes in the UK regressive?

Why has the fall in income been largest for the richest fifth of households since 2007/8? Does this mean that, as the economy recovers, the richest fifth of households are likely to experience the fastest increase in disposable incomes?

VAT was introduced on the 1st of April 1973, as part of the conditions for the UK entering the Common Market. Designed by a French tax expert, Maurice Lauré, it was initially envisaged as a straightforward replacement for purchase tax, which would be applied to most goods and services.

Forty years on, VAT is increasingly complex, with numerous exemptions, many anomalies in its scope, and increasingly expensive challenges to its imposition. How did we get to this point? And is it time for VAT to undergo a mid-life makeover?

All governments have to raise taxes – to redistribute income and to fund public spending. They have a number of mechanisms they can use, but essentially they have to tax incomes (direct taxes), spending (indirect taxes) or a mix of both. The main indirect tax in the UK is VAT, which now raises over £100bn a year, compared with £1.5bn in its first year (see above chart: click here for a PowerPoint version). Initially envisaged as a simple, cross-Europe purchase tax, the current system is complex and at times appears to have been formulated ‘on the hoof’, never a good way to build a tax system.

In the 2012 Budget, the Chancellor decided to apply the standard rate of income tax to hot takeaway pasties; previously they had been zero-rated. However, he had sharply underestimated the ability of the industry to lobby against the tax, working closely with the tabloid press. Perhaps more importantly, he also missed the complex nature of the good; when is a hot pasty just cooling down? And what is hot? The government backtracked and now 20% VAT is only charged on pasties that are deliberately kept hot. You might think that this change of heart avoided introducing an anomaly, but consider how you might feel if you sell takeaway baked potatoes, which are subject to VAT.

Apart from the complexity of the system, VAT is unpopular with some commentators who feel that it falls too heavily on low-income households. Although many foodstuffs are zero-rated and housing is exempt, VAT is charged at 20% on clothing and many necessities such as cleaning materials. Gas and electricity are subject to a reduced rate of 5% and both alcohol and cigarettes have additonal excise duties imposed and yet are disproportionally consumed by the poor. When the standard rate of VAT was temporarily dropped to 15% in 2010, but then permanently raised to 20% in 2011, many felt that this was a shift in the tax burden to the poor.

So complex, irrational and prone to changes following political lobbying or expensive legal cases, VAT does seem to be stumbling into its forties under something of a cloud. However, it remains the case that it raises a large proportion of UK tax revenues at relatively low direct cost and provides the Chancellor with a reasonably effective fiscal policy tool. Even if a government wanted to put in place an alternative, it is likely that the associated political risks would be too high for it to do so. We might hope for some rationalisation of the current system, but there is little doubt that we will be raising a glass to VAT’s 50th birthday in 2023.

The links below include some articles on VAT’s 40th birthday and some more general articles on VAT.

Questions

Explain why VAT might be deemed regressive. Can you formulate an argument that it falls more heavily on the rich than the poor?

Why is VAT administratively cheap? Other than generating tax revenues, can you think of any advantages of the tax?

Newspapers and books are zero-rated in the UK, while e-books and news apps are standard rated at 20%. Can you identify some other anomalies in the UK VAT system? Is there an argument that a better approach would be to charge a lower rate on all goods and services?

Who pays VAT, consumers or producers? Illustrate your answer with a diagram, or two.

A business has to register for VAT once it has a turnover of £77,000 pa. Does this system give rise to any perverse incentives?

Countries across the European Union have varying VAT rates, applied to very different ranges of products. Explain why this might hinder the workings of a single European market.

Imagine you were running a brand new economy; would you use a value-added tax to raise revenues? What are the alternatives open to governments?

The government has proposed charging a levy to people who claim non-dom (non-resident) status in the UK. This levy of £30,000 will be charged on people with non-dom status who choose to shelter their earnings in overseas tax havens. An intensive campaign against the tax has been launched by various elements of the media.